Howard Marks put it well when he said that, rather than worrying about stock price volatility, “The possibility of permanent loss is the risk I worry about … and every investor practice that I know is worried. ” So it seems like smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess the level of risk of a business. We can see that Britvic plc (LON: BVIC) uses debt in its business. But does this debt worry shareholders?
Why Does Debt Bring Risk?
Debt helps a business until the business struggles to repay it, either with new capital or with free cash flow. If things really go wrong, lenders can take over the business. While it’s not too common, we often see indebted companies continually diluting their shareholders because lenders are forcing them to raise capital at a ridiculous price. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. When we look at debt levels, we first consider both cash and debt levels.
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What is Britvic’s debt?
The image below, which you can click for more details, shows Britvic owed £ 628.9million at the end of March 2021, a reduction from £ 757.3million on a year. However, he also had £ 41.8million in cash, so his net debt is £ 587.1million.
How strong is Britvic’s balance sheet?
We can see from the most recent balance sheet that Britvic had liabilities of £ 505.3million due within one year and liabilities of £ 724.2million due beyond. On the other hand, he had £ 41.8million in cash and £ 300.6million in less than one year receivables. As a result, its liabilities total £ 887.1 million more than the combination of its cash and short-term receivables.
Britvic has a market cap of £ 2.49bn, so it could very likely raise funds to improve its balance sheet, should the need arise. But we absolutely want to keep our eyes open for indications that its debt is too risky.
In order to measure a company’s debt relative to its profits, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its profit before interest and taxes (EBIT) divided by its interest. debtors (its interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
Britvic’s debt is 3.3 times its EBITDA and its EBIT covers its interest expense 6.7 times. Overall, this implies that while we wouldn’t like to see debt levels rise, we believe it can handle its current leverage. Unfortunately Britvic’s EBIT has fallen 20% over the past four quarters. If incomes continue to drop at this rate, it will be more difficult to manage debt than taking three kids under 5 to a fancy pants restaurant. There is no doubt that we learn the most about debt from the balance sheet. But it is future profits, more than anything, that will determine Britvic’s ability to maintain a healthy balance sheet in the future. So if you are focused on the future you can check this out free report showing analysts’ earnings forecasts.
Finally, a business can only pay off its debts with hard cash, not with book profits. The logical step is therefore to examine the proportion of this EBIT that corresponds to the actual free cash flow. Over the past three years Britvic has recorded free cash flow of 75% of its EBIT, which is close to normal given that free cash flow excludes interest and taxes. This free cash flow puts the business in a good position to repay debt, if any.
Our point of view
Britvic’s struggle to increase EBIT made us question the strength of its balance sheet, but the other data points we considered were relatively redeemable. In particular, its conversion of EBIT into free cash flow was revitalized. We think Britvic’s debt makes it a bit risky, having considered the aforementioned data points together. Not all risks are bad, as they can increase stock returns if they are profitable, but this risk of leverage is worth keeping in mind. The balance sheet is clearly the area you need to focus on when analyzing debt. However, not all investment risks lie on the balance sheet – far from it. To do this, you need to know the 2 warning signs we spotted with Britvic.
Of course, if you are the type of investor who prefers to buy stocks without going into debt, feel free to check out our exclusive list of cash growth net stocks today.
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